Managing Risks and Benefiting from Risks

Risks


There are numerous risks involved in investing in the stock market.
- Knowing that these risks exist should be one of the things an investor is constantly aware of.
- The money you invest in the stock market is not guaranteed.


For instance, you might buy a stock expecting a certain dividend or rate of share price increase.
- If the company experiences financial problems it may not live up to your dividend or price growth expectations.
- If the company goes out of business you will probably lose everything you invested in it.
- Due to the uncertainty of the outcome, you bear a certain amount of risk when you purchase a stock.


Stocks differ in the amount of risks they present.
- For instance, Internet stocks in 2000 have demonstrated themselves to be much more risky than utility stocks.


One risk is the stocks reaction to news items about the company.
- Depending on how the investors interpret the new item, they may be influenced to buy or sell the stock.
- If enough of these investors begin to buy or sell at the same time it will cause the price to rise or fall.



Managing risks

One effective strategy to cope with risk is diversification.
- This means spreading out your investments over several stocks in different market sectors.
- Remember the saying: “Don’t put all your eggs in the same basket”.


As investors we need to find our “Risk Tolerance”.
- Risk tolerance is our emotional and financial ability to ride out a decline in the market without panicking and selling at a loss.
- When we define that point we make sure not to extend our investments beyond it.


Benefiting from risks

The same forces that bring risk into investing in the stock market also make possible the large gains many investors enjoy.
- It’s true that the fluctuations in the market make for losses as well as gains but if you have a proven strategy and stick with it over the long term you will be a winner!


The Internet has make investing in the stock market a possibility for almost everybody.
- The wealth of online information, articles, and stock quotes gives the average person the same abilities that were once available to only stock brokers.
- No longer does the investor need to contact a broker for this information or to place orders to buy or sell.
- We now have almost instant access to our accounts and the ability to place on-line orders in seconds.
- This new freedom has ushered in new masses of hopeful investors.


Still this in not a random process of buying and selling stock. We need a strategy for selecting a suitable stock as well as timing to buy and sell in order to make a profit.

CONCEPT OF "RISK"

The opposite of risk is safety.

Are good bonds less risky than good preferred stocks?

Are good bonds and good preferred stocks less risky than good common stocks?

Are common stocks, thus, not "safe"?



RISKS IN VARIOUS ASSETS

1. BOND:  A bond is clearly unsafe when it defaults its interest or principal payments.
2. STOCK:  Similarly, if you have bought a preferred stock or a common stock with the expectation that a given rate of dividend will be continued, then a reduction or passing of the dividend means that it is unsafe.  Another risk is, if there is a fair possibility, that the holder may have to sell at a time when the price is well below cost.
3. PROPERTY:  The man who holds a mortgage on a building might have to take a loss if he were forced to sell it at an unfavourable time.  In the judging the safety or risk of ordinary real-estate mortgages, the only criterion being the certainty of punctual payments.
4. BUSINESS:  The risk attached to an ordinary commercial business is measured by the chance of its losing money, not by what would happen if the owner, were forced to sell.

MARKET PRICE DECLINES AND THE STOCK INVESTOR'S WELL SELECTED PORTFOLIO

A bona fide investor does not lose money merely because the market price of his holdings declines; the fact that a decline may occur does not mean that he is running a true risk of loss.

If a group of well-selected common-stock investments shows a satisfactory over-all return, as measure through a fair number of years, then this group investment has proved to be "safe."

During that period its market value is bound to fluctuate, and as likely as not it will sell for a while under the buyer's cost.

If that fact makes the investment "risky" it would then have to be called both risky and safe at the same time.



CONCEPT OF RISK IS SOLELY A LOSS OF VALUE

This confusion may be avoided if we apply the concept of risk solely to a loss of value which either
(a) is realized through actual sale or
(b) is ascertained to be caused by a significant deterioration in the company's position.

Many common stocks do involve risks of such deterioration.

But it is our thesis that a properly executed group investment in common stocks does not carry any substantial risk of this sort and that therefore it should not be termed "risky" merely because of the element of price fluctuation.



MARKET PRICE DECLINE

• The prices of all stocks may decline 
• In fact, other than Savings Bonds, all financial assets' prices can decline.  
• Stocks then to decline to a greater extent than bonds and preferred shares.
• This decline may be of a cyclical and temporary nature and the holder is also unlikely to be forced to sell at such times. 
• Market price decline is not a true risk (in the useful sense of the term).

The concept of risk. Risk = Loss of VALUE

We should apply the concept of risk solely to a loss of value which either

(a) is realized through actual sale or

(b) is ascertained to be caused by a significant deterioration in the company's position or fundamentals.  (Many common stocks do involve risks of such deterioration.)

YOUR PORTFOLIO OF STOCKS AND MARKET PRICE FLUCTUATIONS

A carefully selected and constructed portfolio in common stocks does not carry any substantial risk of this sort, that is, the risk of loss of value.

Therefore, it should not be termed "risky":

• merely because of the element of price fluctuation, which maybe of a cyclical and temporary nature, and,
• moreover, the holder is unlikely to be forced to sell at such times.

Market price fluctuation is not risk; it is the friend of the value investors.

The relationship of risk and potential reward in stock investing is often misunderstood in shaping an investment strategy.

There is no investing in stocks without risk and there is no return without risk.

If you are adverse to the idea of taking any amount of risk, then stocks are not for you.

It will be more difficult (but not impossible) for you to reach your financial goals without investing in stocks.


Understanding Risk

Risk is the potential for your investment to lose money, for a variety of reasons - meaning your stock's price will fall below what you paid for it.

No one wants to lose money on an investment, but there's a good chance you will if you invest in stocks.

The rule of thumb is "the higher the risk, the higher the potential return, and the less likely it will achieve the higher return."

Buying a stock that is risky doesn't mean you will lose money and it doesn't mean it will achieve a 25% gain in one year. However, both outcomes are possible.

How do you know what the risk is and how do you determine what the potential reward (stock price gain) should be?


Measuring risk against reward

When you evaluate stocks as potential investment candidates, you should come up with an idea of what the risks are and how much of a potential price gain would make the risks acceptable.

Calculating risk and potential reward is as much an art as it is a science.

You need to understand the principle of risk and reward to make an educated investment as opposed to a guess.

The most common type of risk is the danger your investment will lose money.

You can make investments that guarantee you won't lose money, but you will give up most of the opportunity to earn a return in exchange.

When you calculate the effects of inflation and the taxes you pay on the earnings, your investment may return very little in real growth.


Will I achieve my financial goals?

If you can't accept much risk in your investments, then you will earn a lower return.

To compensate for the lower anticipated return, you must increase the amount invested and the length of time it is invested.

Many investors find that a modest amount of risk in their portfolio is an acceptable way to increase the potential of achieving their financial goals.

By diversifying their portfolio with investments of various degrees of risk, they hope to take advantage of a rising market and protect themselves from dramatic losses in a down market.

The elements that determine whether you can achieve your investment goals are the following:
1. Amount invested
2. Length of time invested.
3. Rate of return or growth
4. Fewer fees, taxes, and inflation.


Minimize risk - Maximize reward

The MOST SUCCESSFUL INVESTMENT is one that gives you the most return for the least amount of risk.

Every investor needs to find his or her comfort level with risk and construct an investment strategy around that level.

A portfolio that carries a significant degree of risk may have the potential for outstanding returns, but it also may fail dramatically.

Your comfort level with risk should pass the "good night's sleep" test, which means you should not worry about the amount of risk in your portfolio so much as to lose sleep over it.

There is no "right or wrong" amount of risk - it is a very personal decision for each investor.

However, young investors can afford higher risk than older investors can because young investors have more time to recover if disaster strikes.

If you are 5 years away from retirement, you don't want to be taking extraordinary risks with your nest-egg, because you will have little time left to recover from a significant loss.

Of course, a too-conservative approach may mean you don't achieve your financial goals.

The Sources of Risk in Stock Investing

Total Risk = Unsystematic Risk + Systematic Risk

Unsystematic Risk (diversifiable)
Business Risk
Financial Risk

Systematic Risk (nondiversifiable)
Market Risk
Interest Rate Risk
Reinvestment Rate Risk
Purchasing Power Risk
Exchange Rate Risk

RISKS: Not Dead Yet: Surviving Today to Triumph Tomorrow

Portfolio philosophy
Long term investing
Concentrated portfolio
Undervalued micro-cap growth companies
10-15% stake in each company
Active constructive engagement
Friendly long-term 7-9 years average ownership
Aim to build shareholder value

Risks
Return of my capital is more important than return on my capital.  Live to see another day.  Risk is real.
Risk has to be managed - at portfolio level and at company level.
Risk is not Beta or price fluctuation (volatility). To say these are risks is nonsense.
The sharp falls of 2007 to 2009, puts the academic theories of market efficiency and its utility in question.
What is taught in business school is questionable.
For example, the Madoff fund provided steady 10%-15% annual return with little volatility.
By definition, Madoff's fund had low Beta and was not risky but it is virtually a total permanent loss today except for some clawback in value from litigation.
Risk is not rotational short term loss given a long term investment orientation.
If is is not permanent, it can come back, and often it can come back very quickly.
To a trader, these rotational short term losses are often permanent and market losses are real.
Market fluctuations bring pain and fear and are viewed as opportunities, to sell or to back up the truck when Mr. Market is upset.
What are the real risks facing the investment managers?  What are the risks in investing in a single company?

Risks facing the investment manager.

Leverage risk
Leverage is lethal.
LTCM was leveraged 50 - 100:1
Bear Stern and house of cards were leveraged 50:1
Leyman was also in the comparable area.
What does leverage of 50:1 mean?
If the asset is worth 100 sen, your equity is 2 sen.
A 2% downward fluctuation will wipe out all your equity.
The stock market has seen more 2% fluctuations in the 7 months of 2011 than in the last 13 years.
Leverage magnifies the risk of loss.
We don't use leverage to magnify our return.
The only time for using leverage is as a temporary bridging source of liquidity when we found something we wish to buy, until our liquidity of fund is available.

Redemption risk.
Investors of fund tend to cash out at the worst possible time.
Selling the stocks in a fund to pay investors at this time is not the best practice.
Therefore, all new investors are educated and their funds are locked in for at least 5 years.

Other risks:
Counter party risk.
Custodian risk.
Regulatory risk.
Execution risk
Fraudulent earnings risk.

.
Risks facing the individual investment

Debt risk
Net cash position.  Debt, if used, should be modest in relation to trough EBITDA.  Preferably long term debt used to fund business.

Legal and regulatory risk
High level of these risks should make you stay away.

Market development risk
Not interested in start ups.

Competition risk
Invest in the leader in the industry with a big moat.

Execution risk
Embrace management team that can execute their strategy.

Valuation risk
We like to back up the truck to scoop when the value is good.

Exit strategy risk
Multiple pathway can be worked with the management team to make for more liquidity.

Fraudulent risk.
Check out carefully.  Due diligence.

http://valueinvestingletter.com/not-dead-yet-surviving-today-to-triumph-tomorrow.html

Buy and Hold (Return vs Risk)

Why Investment Risk Increases Over Time

August 10, 2010, 11:26 AM

By CARL RICHARDS

Carl Richards

Carl Richards is a certified financial planner and the founder of Prasada Capital.

Spend any time hanging out with traditional financial services salespeople or in the investment section of Barnes & Noble and you’ll no doubt hear the claim that risk declines over time.

This story is often accompanied by an “educational” piece that looks something like the sketch above. The message is that over time, the range of potential investment returns narrows toward a long-term average of about 10 percent.

In other words, when you look at the best and worst returns for the stock market for any one-year period, you could have lost over 40 percent or gained over 60 percent. That’s a really wide range.

But when you look at 20-year periods, the worst average annual performance was a gain of around 3 percent with the best being about 15 percent. That’s a much more narrow range. Over 30 years, things get even closer to the average.

The problem is real people in the real world don’t really care about percentages. We care about dollars. No matter how hard you try, you can’t pay for food, college or retirement with a bucket full of percentages.

And when we measure the same range of potential outcomes over time, only this time we do it in dollars, you get the opposite picture. The potential outcomes get wider over time.

If you happen to earn 5 percent instead of the 7 percent you planned on, it will make very little difference 12 months from now. But in 20 or 30 years, you will end up in a greatly different place.

Think of it as a cross-country flight leaving from Los Angeles and heading to Miami. If you’re a half-inch off when you take off, you will hardly notice when you fly over Las Vegas. Fail to make a course correction, however, and you run the risk of ending up in Maine instead of Miami.

It’s a wild paradox, but most of the educational stories and tools used by the investment and personal finance industry are focused on investments, not investors, and on percentages, not dollars. A study released recently came to a similar conclusion using much more detailed reasons as to why, but the message is the same. Risk actually increases over time, contrary to the expectations of the industry.

This is part of the reason that financial plans are worthless, but the process of planning is vital.

If you base your plan on earning the long-term average return of the stock market and never make course corrections, you’re at great risk of ending up someplace other than where you planned. On the other hand, if you set a course and then make slight course corrections when you find you have veered off, you can home in on your destination.

http://bucks.blogs.nytimes.com/2010/08/10/why-investment-risk-increases-over-time/

Click:  Savings Calculator: The Big Difference a Single Percentage Point Makes

Increasing your savings by one more percentage point – or even better, another percentage point a year – can add up to big additional savings over time.

Click:  Three most important personal factors to consider: Your Time Horizon, Risk Tolerance and Investment Objectives

Risk of Loss Caused by Infrequent Trading

Investment assets that are seldom traded may be difficult to sell unless you are willing to offer a price concession to attract a buyer.  It is especially difficult to obtain a fair price when you are in a hurry to sell an asset that has little trading activity.

Many stocks are actively traded and offer excellent liquidity to a seller; even when it it necessary to sell the stocks immediately.  At the opposite end of the liquidity scale, some stocks in which limited trading occurs may be difficult to sell on short notice unless you are willing to accept a price that is substantially lower than would be received in an active market.

The ownership of inactive stocks is not a great concern if you are investing for the long term.  The common stocks of relatively small, little-known companies frequently offer an opportunity to earn large capital gains.  Unfortunately infrequent trading caused by a current lack of investor interest means that you may have difficulty disposing of the stock at a reasonable price on very short notice.

• If you are investing to achieve short- or intermediate-term goals and expect that you will have to sell your stocks in the not-too-distant future, owning stocks that don't have an active secondary market is a risky investment choice.  
• You can avoid this risk by limiting your selections to stocks that are actively traded on one of the organized exchanges or in the over-the-counter market.

The Risks of owning Common Stocks

The risk of investing is directly related to the uncertainty of the rate of return that you will earn.  The less certain the return, the greater the risk.  

The risk of an investment is especially great when there is a possibility that a large negative return (that is, a substantial loss) can result.  

Thus, common stocks are more risky than bonds, and bonds are more risky than savings accounts.  Insured certificates of deposit and U.S. Treasury bills, are considered to be virtually risk free because of the certainty of how much money will be received and when the receipt will occur.

Common stocks can be very risky investments to own for a number of reasons.  

1.  Nearly all common stocks subject investors to substantial uncertainty regarding the rate of return that will be earned.  Stock prices are extremely volatile, and it is not unusual for the market price of a common stock to move upward or downward by 30% or more during a year.

You might make the argument that you haven't actually lost 30% if you don't sell at the low price, but what if it goes lower?  In any case, for example, you paid $50 for an investment that is now worth only $35.  This represents a loss of your wealth regardless of whether you sell or keep the stock.

2.  The flow of dividend income from common stocks is often difficult to forecast because, unlike a bondholder's promised interest payments that are a legal obligation of the issuer, a company's board of directors must vote to approve dividend payments to the firm's stockholders.  In other words, common stockholders have no legal right to receive dividend payments.

• The directors of a company that encounters financial difficulties may decide to reduce or even eliminate dividend payments to stockholders.  
• Directors of a company may also decide to revise a firm's direction and reduce the dividend in order to increase the amount of money that is available for expansion.  
• Even the directors of a successful company may not increase the dividends as much as investors expect.  
• What a company may pay in dividends is much easier to estimate accurately in the near term than the long term, because it is difficult to forecast the business conditions a firm will face several years in the future.  New competition, new products, changing consumer preferences, and an uncertain economy all serve to make it difficult to forecast future corporate profits and dividends.

3.  A variety of factors can affect the return you will earn from holding shares of common stocks.

• Unexpected inflation, rising interest rates, and deteriorating economic conditions can each be expected to have a negative impact on most common stock values.  
• In addition, the shares of small, little-known companies may be difficult to sell without accepting a large price penalty.  

As investors discovered during the stock market meltdown of 2008, risk is an important issue to consider if you plan to invest in common stock.

The Performance Illusion: Higher returns have long been associated with higher risks.

Which would you rather have, a portfolio with an average annual return of almost 34%, or one with an average annual return of just 5%?  Let's llok at a couple of examples that show why sometimes less is more.

Exhihit 1
The  Performance Illusion:  High Average Return

Year 1
Starting Value $100,000  Return 100%  Gain or (Loss) $100,000
Ending Value $200,000

Year 2
Starting Value $200,000  Return -99.00%  Gain or (Loss) ($198,000)
Ending Value $2,000

Year 3
Starting Value $2,000  Return 100%  Gain or (Loss) $2,000
Ending Value $4,000

Average Annual Return: 33.67%
Change in Value: ($96,000)
Percentage of Initial Investment Gained or (Lost) after 3 years: -96%



Exhihit 2
The  Performance Illusion:  Low Average Return

Year 1
Starting Value $100,000  Return 15%  Gain or (Loss) $15,000
Ending Value $115,000

Year 2
Starting Value $200,000  Return -15%  Gain or (Loss) ($17,250)Ending Value $97,750

Year 3
Starting Value $97,750  Return 15%  Gain or (Loss) $14,662.50
Ending Value $112,412.50

Average Annual Return: 5%
Change in Value: $12,412.50
Percentage of Initial Investment Gained or (Lost) after 3 years: 12.41%


Which return would you rather have? Of course, to illustrate the dangers of a high-volatility approach to investing, these two examples include an extreme case. Surely no one would ever face the kind of volatility shown in the 100 percent up and 99 percent down example ... but they might come close.



Exhihit 3
Nasdaq Composite Index

Year 1999
Starting Index Value 2192.69; Return 85.59%; Point Gain or(Loss) 1876.62
Ending Value 4069.31

Year 2000
Starting Index Value 4069.31; Return -39.29%; Point Gain or(Loss)(1598.79)
Ending Index Value 2470.52

Year 2001
Starting Index Value 2470.52; Return -21.05%; Point Gain or(Loss)(520.12)
Ending Index Value 1950.40

Year 2002
Starting Index Value 1950.40; Return -31.53%; Point Gain or(Loss)(614.89)
Ending Index Value 1335.51

Year 2003
Starting Index Value 1335.51; Return 50.01%; Point Gain or(Loss)667.86
Ending Index Value 2003.37

Average Annual Return: 8.74%
Change in Index: -189.32
Percentage of Initial Investment Gained or (Lost) after 5 years: -8.63%


Exhibit 3 shows the actual results of the Nasdaq Composite Index (Nasdaq) over five years beginning in 1999 and ending on December 31, 2003.

The truly remarkable 86% return posted by the Nasdaq in 1999 was followed by a truly gruesome bear market mauling over the three years. From the start of 2000 to the end of 2002, the Nasdaq shed an amazing 2,733 points - more than 67% of its value. The year 2003 brought welcome relief, but even after a 50% rise, the Nasdaq was still more than 8.6% below where it had stood five years earlier.

An investor unlucky enough to have missed out on the gains over this time span - either by coming late to the party or bailing out before the rebound - would have suffered a massive financial setback. As of the end of 2003, the Nasdaq remains more than 3,000 points, or 60%, below its all time closing high.


Exhibit 4
The Y2K Bear Market

Nasdaq
Index Closing High 5048.62
Date Hit 03/10/2000
Index (On 12/31/2003) 2003.37
Decline -60.32%
Points from High 3045.25
Gain Needed to Recover 152.01%

S&P 500
Index Closing High 1527.45
Date Hit 03/24/2000
Index (On 12/31/2003) 1111.92
Decline -27.20%
Points from High 415.53
Gain Needed to Recover 37.37%

DJIA
Index Closing High 11722.98
Date Hit 01/14/2000
Index (On 12/31/2003) 10453.92
Decline -10.83%
Points from High 1269.06
Gain Needed to Recover 12.14%


The Exhibit 4 shows the damage the Y2K bear market has visited on three major U.S. stock market indexes. The S&P 500 and DJIA did not soar nearly as high as the Nasdaq during the technology/telecom/Internet boom of the 1990s, and they suffered much less damage during the bust that followed.

The scenarios above are to illustrate, that there are consequences to taking risks. The easy success of the late 1990s bull market lulled many investgors, including many professional investors, into believing risk had lost its bite. Why not shoot for a 30 percent return? If you don't get it, you'll probably just have to settle for 20%. But that's not how it works in the real world - at least not in the long run. The experience of the Nasdaq versus the DJIA during the Y2K Bear Market wasn't a fluke. Higher returns have long been associated with higher risks.

Social risk

Social risk

Social risk is difficult to quantify. It reflects the potentially adverse impact changing public attitudes can have on a firm’s ability to sell its product.

It is really a form of business risk that impacts a specific firm or industry.
· No one likes ugly smoke-stacks, for instance. Local opposition to apparent pollution might lead to a boycott of company products.
· Past examples of social risk issues include nuclear power, the spotted owl, furs, cigarette advertisements, concern with cholesterol, and the gasoline consumption of SUVs.

According to the Social Investment Forum, there is more than $2 trillion invested in socially screened portfolios in the United States. This is a 47% increase since 1999.

While there are various social screening criteria, avoiding tobacco investments is the most common.

Other criteria appearing in more than half of the institutional screens are related to
· the environment,
· human rights,
· employment/equality,
· gambling,
· alcohol, and
· weapons.

Less common criteria involve
· labour relations,
· animal testing/rights,
· community investing,
· community relations,
· executive compensation,
· abortion/birth control, and
· international labour standards.

Social investing does not necessarily avoid things; sometimes it seeks things out, and not always with good outcomes.
· In 1990 the state of Connecticut Employee Pension Plan, under political pressure, invested $25 million in the stock of Colt Firearms in order to keep 925 local jobs from being lost. Colt filed for bankruptcy 2 years later. This government attempt to help one group of citizens wound up hurting another, as the entire investment was lost.


Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk

Political risk

Political risk

Political risk reflects the possibility that a foreign government will interfere with a firm’s preferred manner of conducting business.

The level of interference can be modest, such as requiring that a certain number of first-line supervisors be local nationals rather than “foreigners.”

More severe instances of political risk include:
· restrictions on the repatriation of dividends,
· mandatory local investments, or
· even the host-country government assuming control of the foreign firm through nationalization.

For multinational corporations, political risk is a fact of life. Firms learn to estimate the level of this risk in different parts of the world, as well as how to reduce its impact and to postpone or avoid its effects.


Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk

Foreign exchange risk

Foreign exchange risk

Foreign exchange risk reflects the possibility of loss due to adverse changes in the relative values of world currencies.

Suppose an investor buys securities in an Australian company for AUD25 at a time when the exchange rate is one Australian dollar per 75 cents U.S. One year later the share price is AUD30, and 70 cents will buy one Australian dollars.
· To an Australian, the shares appreciated by 20%, from AUD25 to AUD30.
· From the perspective of a U.S. investor, the adverse change in the exchange rate reduced the actual gain on the investment to 12%. The U.S. investor wants to begin and end with U.S. dollars.
· Foreign exchange risk reduced the true economic return from a U.S. investor’s perspective.


Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk

Interest rate risk

Interest rate risk

Interest rate risk is the chance of a loss in portfolio value due to an adverse change in interest rates.

When interest rates change, the value of a fixed income security also changes.

Rising interest rates depress bond prices, and vice versa.

Default risk: Default risk is the same as credit risk. It reflects the fact that a borrower might be unable or unwilling to honour the terms of an agreement to pay principal and interest on a loan.


Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk

Purchasing power risk

Purchasing power risk

Purchasing power risk reflects the possibility that the rate of return on an investment will be insufficient to offset the rise in the cost of living.

During the early 1980s, the prime interest rate rose to 23% and inflation hit double-digit rates. At the same time, passbook savings accounts yielded about 5%. In retrospect, bank depositors would have been better advised to purchase canned goods and stack them in the basement. The interest earned from the savings account would have been insufficient to match the increase in the cost of food.

The stock market is generally considered to be a hedge against inflation. (Some analysts disagree with this generalization. Over long periods it is true; over shorter periods in history, it has not always been true.)

A well-diversified stock portfolio has little purchasing power risk, while an investment in fixed rate securities has plenty of it.


Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk

Financial risk

Financial risk

Financial risk is associated with the bottom of the income statement; it deals with earnings and how business risk and the financial structure of the firm impact them.

This type of risk is related to the firm’s use of financial leverage (debt).

Interest payments are fixed costs the firm must pay to stay out of bankruptcy, regardless of the firm’s profitability.

Some people, in fact, will say that a firm with no debt has no financial risk.


Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk

Business risk

Business risk

Business risk is the variability in a firm’s sales or in its ability to sell its product.

It is associated with the top of the income statement.

Business risk surfaces for a number of reasons.

1. For instance, consumer tastes may change.
   
2. An automobile company might introduce a new compact car at a time when people are looking for larger luxury cars or minivans.
   
3. A clothing manufacturer might be unable to react quickly to shifting fashion styles.
   
4. Business risk also arises from macroeconomic changes, such as

• a recession leading to reduced consumer spending, or
• high interest rates making people reluctant to buy houses.

Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk

Partitioning Risk

Partitioning Risk


Risk has many subsets.


Total risk is all-inclusive and refers to the overall variability of the returns of a financial asset.


The two components of total risk are
· Un-diversifiable risk (also called systematic risk or market risk) and
· diversifiable risk (also called unsystematic risk).


Undiversifiable risk is that which must be borne by virtue of being in the market. This risk arises from systematic factors that affect all securities. We quantify systematic risk by beta.

Subsets of Risks:

Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk

Risk and the Income Statement
Sales: Foreign exchange risk, Social risk, Business risk
Tax: Political risk
Dividends: Political risk
Contribution to Retained Earnings: Financial risk

Risk and the Balance Sheet
Total Assets
Financial assets: Interest rate risk, default risk, systematic and unsystematic risk, foreign exchange risk.
Real assets: Foreign exchange risk

Total Liabilities and Net Worth
Liabilities: Interest rate risk, foreign exchange risk
Net worth: Purchasing power risk

Managing Investment Risk

Risk equals the potential that actual returns will differ from expected returns.

1. The best way to manage risk is to allow yourself ample time. Start investing now rather than later. When you have time on your side, more of your money can be invested in stocks rather than in bonds and money market instruments because you would have a larger capacity to ride the ups and downs of the stock market.

2. Secondly, you can manage risk by diversifying your money into stocks, bonds and money market investments. This is called asset allocation.

3. Finally, the way you divided your investments depends on your specific situation and your goals. Spend some time thinking about the best way to divide your money based on your needs and the type of risk you can take. This exercise will make a big difference to your investment success.

Ref: Make Your Money Work for You, by Keon Chee & Ben Fok